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Response to ESMA on DLT Applied to Securities Markets

Presented at the Post Trade Distributed Ledger working group
London, November 1, 2016

The response to ESMA is available at https://drive.google.com/drive/folders/0B8tGDTaBY4-Nb3ZuRmgzRXJXOUk

Distributed Ledger Technology (DLT) is in a very early stage of development. Sometimes confused with the blockchain technology underlying bitcoin, it is supposed to be its evolution designed to avoid the architectural choices that make bitcoin and blockchain unsuitable for securities settlement and financial applications. DLT is enjoying the blockchain hype originating from the resiliency of bitcoin operations, but it still lacks a reference implementation or strict technical specifications, beyond being a shared ledger using cryptographic tools. As such, it is difficult to discuss its promises and limitations. Nonetheless, some considerations are possible starting from the existing market infrastructure, the experience with operational blockchains, and the available elements of the public debate about DLT.

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Response to ESMA on DLT Applied to Securities Markets

  1. 1. Response to ESMA/2016/773 The Distributed Ledger Technology Applied to Securities Markets Ferdinando M. Ametrano, E. Barucci, D. Marazzina, S. Zanero https://drive.google.com/drive/folders/0B8tGDTaBY4-Nb3ZuRmgzRXJXOUk @ferdinando1970 ferdinando@ametrano.net http://www.slideshare.net/Ferdinando1970 Post Trade Distributed Ledger Working Group, London, November 1, 2016
  2. 2. “Blockchain – not bitcoin – will prove revolutionary in banking” http://www.economist.com/news/leaders/21677198-technology-behind-bitcoin-could-transform-how-economy-works-trust-machine 2/25
  3. 3. Why Bitcoin Is Hard To Understand At the crossroad of: 1. Game theory 2. Cryptography 3. Computer networking and data transmission 4. Economic and monetary theory Mainly not a technology, a cultural paradigm shift instead 3/25
  4. 4. Understanding Lags Well Behind The Hype Understanding of the technology however lags well behind the hype, amongst practitioners, policy makers and industry commentators alike. ‘Blockchain’ technology seems to promise major change for capital markets and other financial services – some say it may ultimately prove to be as important an innovation as the internet itself – but few can say exactly how or why. Michael Mainelli, Alistair Milne (2016) The Impact and Potential of Blockchain on the Securities Transaction Lifecycle http://ssrn.com/abstract=2777404 4/25
  5. 5. What is The Blockchain? [A hash pointer linked list of blocks] • An append-only sequential data structure • New blocks can only be appended at the end of the chain • To change a block in the middle of the chain, all subsequent blocks need to be changed • Very inefficient compared to a relational database 5/25
  6. 6. Blockchain: A Distributed Transaction Ledger • Every block contains multiple transactions • Massively duplicated across network nodes • Shared with a P2P file transfer protocol • Updated by peculiar nodes, known as miners, appending new blocks of transactions 6/25
  7. 7. A Distributed Back-office • All network nodes perform transaction validation and clearing • Miners perform the additional work required for settlement. How do they reach consensus on the transaction history? • Consensus in a distributed network with faulty (or malicious) nodes is a very hard problem known as Byzantine General Problem 7/25
  8. 8. Distributed Consensus • Nakamoto reaches consensus using (game theory) economic incentive for the mining nodes to be honest • Miners are compensated for their proof-of- work using seigniorage revenues, i.e. with issuance of new bitcoins 8/25
  9. 9. Blockchain Without Bitcoin Does it make sense? No bitcoin No asset available to reward miners Appointed validator officials required Why should validators use a blockchain, i.e. a subpar data structure, instead of a database? 9/25
  10. 10. What Makes Bitcoin Special? • It is scarce in digital realm, as nothing else before • It can be transferred but not duplicated • (i.e. it can be spent, but not double-spent) Bitcoin is digital gold: this is the brilliant groundbreaking achievement by Satoshi Nakamoto 10/25
  11. 11. Blockchain Needs A Native Digital Asset https://www.finextra.com/videoarticle/1241/blockchain-needs-a-native-digital-asset Ferdinando Ametrano, Head of Blockchain and Virtual Currencies, Intesa Sanpaolo, discusses the relationship between bitcoin and blockchain, and outlines how banks can stay ahead of this evolving landscape. 11/25
  12. 12. Why is finance fascinated with blockchain? Blockchain transactions are immediately validated and cleared, then settled shortly thereafter, automatically without a central authority • In the financial world, cash transactions only are cleared and settled automatically without a central authority 12/25
  13. 13. Consensus by reconciliation • Financial transactions that take milliseconds to execute, clear and settle in days • Not a technological problem • Consensus by reconciliation of multiple independent ledgers: a checks and balances system that allows for prescriptions, corrections, and restrictions 13/25
  14. 14. Instant Settlement • If it is really instant and final, what about the mandatory recourse mechanism and rules? • It would reduce liquidity making leverage, short selling and netting almost impossible • It costs: who should pay for it? 14/25
  15. 15. Cash On The Ledger • Cash-on-the-ledger is imperative for Delivery vs Payment • absent from the agenda of prominent players promising DLT solutions 15/25
  16. 16. Cash On The Ledger • Central bank digital currency is problematic: [… it] is appealing […] it would mean people have direct access to the ultimate risk-free asset [...] it could exacerbate liquidity risk by lowering the frictions involved in running to central bank money [...] it could fundamentally and perhaps abruptly re-shape banking. Mark Carney, Governor of the Bank of England, June 2016 http://www.bankofengland.co.uk/publications/Documents/speeches/2016/speech914.pdf • IMF sponsored blockchain tokens might replace Special Drawing Rights: unrealistic as it would severely undermine US dollar predominance • A free instantaneous P2P payment network is a great opportunity for retail banks (probably worth a consortium) 16/25
  17. 17. DLT for Derivatives Clearing • collateral amount calculation is computationally intensive: not clear which agent would perform it, its economic incentive, which models it should use • variation margin automated payments: programmatic access to payment funds entails huge operational risks • the default of counterparty would leave the other party exposed to the market risks usually covered by initial margin: i.e. initial margin are still required 17/25
  18. 18. The Mirage of Low Operational Costs • If one takes into account the seigniorage revenues invested, each transaction on the bitcoin blockchain has a cost of about 5-10USD • Cheaper forms of consensus have not been proven yet • Even in the case of basic bilateral consensus through digital signatures (something hardly innovative or disruptive...) the integration cost in the existing infrastructure is not going to be irrelevant 18/25
  19. 19. Time-stamping and Notarization • A generic data file can be hashed to producing a short unique identifier, equivalent to its digital fingerprint. • Such a fingerprint can be associated to a bitcoin transaction (irrelevant amount) and hence registered on the blockchain • Blockchain immutability provides non-repudiable time-stamp, proving the existence of the data file in that specific status at that moment in time. • This process is undergoing standardization: third party auditability makes it suitable for regulatory prescriptions 19/25
  20. 20. Anchoring: A New Security Paradigm • Bitcoin blockchain network security is preserved by a computation power unparalleled in human history • Other transactional networks can tap into this security via anchoring (i.e. periodic time- stamping of the network status) • Bitcoin miners as global outsourced decentralized security of the future 20/25
  21. 21. Data Storage, Consensus, Security Questions always to be answered: • Can be achieved with a database? • What consensus is required? (distributed, bilateral, centralized) • What kind of security is required: preventive, detective, or corrective? (ok / yes today, probably not in the future/ no) 21/25
  22. 22. New Regulatory Framework? • Public permissionless blockchains are not aiming for regulation • Private permissioned DLTs are supposedly being built from the ground up according to regulatory compliance guidelines • Regulators should examine DLT under the light of the existing regulatory framework • To regulate in advance on the basis of vague ephemeral discussions about DLT would be problematic and might stifle innovation. • The necessity for ad-hoc regulation is not evident yet, and there has not been a motivated explicit request for it. 22/25
  23. 23. Single Shared Data Set • Single data source, avoiding reconciliation • Without a central governing node how to manage priorities between conflicting updates? Which consensus model? • Bilateral consensus? Really?!?!? • Central governance: back to DB admin • What if the single authoritative data source is hacked? Which reference can be used to fix it? 23/25
  24. 24. Improved Automation: Smart Contracts • The DAO (decentralized autonomous org): the main Ethereum project, it raised >$160m as leaderless Venture Capital • The terms of The DAO are set forth in the smart contract code […] Nothing […] may modify or add any additional obligations or guarantees beyond those set forth in The DAO’s code • Based on its self-executing nature an agent diverted about $50m from The DAO to its own child-DAO start-up • If code is law, then this is not a theft: it is a feature • Beware of extreme automation 24/25
  25. 25. Conclusions • Blockchain needs a native digital asset such as bitcoin; • Bitcoin is digital gold and can be as relevant as physical gold for the history of money, finance, and civilization • Unrealistic expectations arise from distributed ledger hype: no reference implementation has emerged yet • Instant settlement, cash on the ledger, shared data set, and improved automation are not easy to obtain • Time-stamping and anchoring are promising applications • Hardly disruptive, DLT might be evolutionary DB tech • F. Ametrano, E. Barucci, D. Marazzina, S. Zanero https://drive.google.com/drive/folders/0B8tGDTaBY4-Nb3ZuRmgzRXJXOUk 25/25